Understanding the Free Trade Agreement (FTA) with particular reference to Aus-United States FTA

Understanding the Free Trade Agreement (FTA) with particular reference to Australia-United States FTA

Sam Choon Yin

October 2004



Economists have argued that increasing the volume of trade brings forth benefit to the participating countries. In this respect, globalism efforts like those in support of World Trade Organisation (WTO) initiatives are recommended. But past experiences have shown that the WTO negotiations took a long time to realise (the Uruguay Round for example took seven years to complete instead of four years as scheduled); not surprisingly because more countries are involved in the negotiation process. As such, reaching a consensus is deemed more problematic and time consuming particularly when it comes to negotiating sensitive issues like liberalisation of the agriculture sector and human rights.

            Second best initiatives like regionalism and bilateralism have thus become increasingly common. Examples of the former include the European Union (transferred from the common market status) and the proposed ASEAN Free Trade Area (AFTA) agreement (intended to complete by 2002 but delayed). Bilateralism initiatives include free trade agreements (FTAs) which involve two participating countries agreeing to remove all trade barriers among them but each having its legitimate power to implement trade policies with non-member countries. Sen (2004) has noted that as of December 2002, there are close to 250 FTAs notified to the WTO of which 130 were established after January 1995 and over 170 currently in force.

            Both regionalism and bilateralism efforts are allowed by the WTO under Article 24 of the original General Agreements on Trade and Tariffs (GATT) provided that two conditions are met. First, members must remove substantially barriers to trade among themselves and second, members must not raise tariffs or other barriers to non-members while removing them among members.

Some of the recently negotiated FTAs include the Australia-United States FTA signed in February 2004, Singapore-New Zealand FTA signed in August 2000, Singapore-Japan FTA signed in January 2002, Singapore-Australia FTA signed in February 2003 and Singapore-United States FTA signed in May 2003. Singapore, to date, has signed more than 20 FTAs with individual countries, while Australia has signed three (New Zealand, Singapore and United States) with intentions to further enhance cooperation with Thailand and Japan. In the next section, I will discuss the pros and cons of forming the FTAs.


Is forming FTAs beneficial?

            The benefits can be categorised into static gains and dynamic benefits. The static effects essentially focus on how trade agreements may have impacted the society’s welfare at a particular point in time. There are two opposing outcomes known as trade creation and trade diversion popularised by Jacob Viner (1953) and James Meade (1955). According to Salvatore (2001) (who was referring to customs union), trade creation occurs when ‘some domestic production in a nation that is a member of the custom union is replaced by lower-cost imports from another member nation’ (p. 329) while trade diversion occurs when ‘lower cost imports from outside the customs union are replaced by higher cost imports from a union member (ibid, p. 330).

            To illustrate these concepts, consider a hypothetical example with three nations: US, Australia and Indonesia. Suppose that the good in consideration is labour intensive, and Indonesia has relatively more abundant of labour than the other two nations. According to the Heckscher-Ohlin theory, Indonesia should specialise in and export the good. Thus, prior to any integration, Australia should import the good from Indonesia (the latter being the most efficient producer). If Australia imposes a uniform tariff, Australia should still choose to import from Indonesia.

Now suppose that US and Australia sign a FTA such that the tariffs initially imposed by Australia on US are removed, so much so that the US imports have become ‘cheaper’ as compared to Indonesia (since the tariffs imposed on Indonesian products still imply). Trade is diverted in this case from the lowest cost producer (Indonesia) outside of the FTA to a relatively less efficient producer (US) inside the FTA leading to a decline in Australia’s welfare. But trade creation also takes place. Since US is (still) more efficient than Australia in the production of the traded good, the FTA expands trade between the two nations thus leading to gains in Australia’s welfare.

The net effect on Australia social welfare is indeterminate as it depends on the relative magnitude of trade creation and trade diversion. Obviously, Australia gains from signing FTA with the US if trade creation effect outweighs that of trade diversion. The converse is true. That is, the society’s welfare deteriorates if the ‘loss’ due to trade diversion outweighs the gains attributed to trade creation. Meanwhile, Indonesia losses since it no longer exports to Australia, at least as much as before. Essentially because of trade diversion, regionalism and bilateralism efforts are viewed as second best.

But the above illustration contains flaws. It leaves out the dynamic benefits of economic cooperation. In the above example, Indonesia may gain over time from the US-AUS FTA (AUSFTA) since expansion in US and Australian economies could lead to greater demand for exports from the Indonesian economy.

This may turn out to be true in reality. According to a report prepared by the Centre for International Economics (based in Canberra), the signing of AUSFTA is expected to benefit New Zealand, a third party, as the latter enjoys from Australia’s expansion. In addition, it is believed that New Zealand will pick up ‘some of the trade diversion in dairy products as Australia shifts product from Asian markets to the United States’ (CIE, 2001, p. viii).

Another benefit of economic cooperation pertains to inflow of investment to member countries. Economic integration spurs outsiders to set up production facilities within the blocs to avoid the (discriminatory) trade barriers imposed on non-members (Salvatore, 2001). This is possibly resulted from greater certainty in investing in these countries in view of the binding agreements which state explicitly areas concerning treatments of imports, exports, investments and others. 

A related benefit is that the FTA could allow firms in the member countries to enjoy a larger market share and reap economies of scale. This point is put forward succinctly in an excellent book authored by Edward Lincoln. In it he wrote:

‘If the bloc has barriers to inward investment from the rest of the world, then formation of the bloc enhances the possibility of expanding sales and reducing average production costs in domestic industries characterised by economies of scale… This possibility is simply a bloc version of what is known in economic theory as strategic trade – using import barriers to help up a domestic industry to an efficient size in order to gain an advance in global competition’ (Lincoln, 2004, p. 162).

Formation of trade bloc could also increase competition. Otherwise, firms (particularly those in the oligopolist and monopolistic competitive market structures) may become complacent and grow sluggishly behind trade barriers. With competition and liberalisation, the firms are likely to lower their average cost of production and enhance their competitiveness thus increasing their productivity and profitability. This is expected in the case of AUSFTA with the resulting liberalisation of services sector. Unlike merchandise goods where both counties already have low or zero tariffs on them, liberalisation of services trade is one of the key issues in the negotiation. In the CIE study noted earlier, the removal of trade barriers is expected to lower cost and boost productivity in the services sector leading to positive welfare gains (CIE, 2001) (more about this later).

Furthermore, economic integration could lead to greater utilisation of capital and labour because of their freer movement within the bloc. According to the Heckscher-Ohlin-Samuelson theorem, the above could lead to convergence in the factor prices. Certain parties however may not welcome this. In relatively more capital abundant countries for example, there may be rejections from labour union because of deterioration of real wages in these countries as predicted by the theory, possibly leading to political, social and economic chaos. Thus, while economic integration could be viewed positively when one talks about allocative efficiency and productive capabilities, it is important to be mindful and cautious when one considers the distributive effect.

Having briefly discussed the possible benefits and costs of forming a trade bloc, I will proceed to discuss how likely some of these will realise with particular reference to the AUSFTA.


Empirical work: AUSFTA

            I will focus on the AUSFTA to illustrate the arguments for and against bilateral economic integration.

            The US and Australia successfully concluded the negotiations on a Free Trade Agreement (FTA) in February 2004. Together, they have a market of over 300 million consumers. Australia had earlier signed FTAs with New Zealand and Singapore, and in negotiation to enhance economic integration with Thailand and Japan. The bilateral initiative supplements rather than replaces the globalism and regionalism drives (US and Australia are strong supporters of the WTO initiatives and both are members of Asia Pacific Economic Cooperation).

            Broadly, the AUSFTA increases US access to all of Australia’s manufactured goods, improved access for Australia’s agricultural sector (with notable exception of sugar), liberalisation of the services trade in professional and financial services, and liberalisation of Australia’s foreign investment rules (CIE, 2004, p. 1).

According to Australia’s Trade Minister, Mark Vaile, the benefits of forming the FTA include, (1) the attraction of additional American investment to Australia, with consequent positive effects on employment and productivity (there should also be additional investments in Australia from non-member countries), (2) greater integration of business in the two markets, enabling new synergies in areas such as research and development, materials sourcing, marketing and use of information technologies, (3) fostering of ‘competitive liberalisation’ through its demonstration effects in the WTO and other trade fora, and (4) engendering a broader appreciation of the bilateral alliance and the role of the two countries in underpinning stability and prosperity in East Asia and the Pacific (quoted in Stoler, 2003b, pp. 4-5).

Before the negotiations are completed in February 2004, there are at least four studies, which have attempted to quantity the economic impacts of the FTA on the Australian economy and they all came out with different conclusions (Stoler, 2003a, p. 301). There were numerous studies that had addressed the impacts qualitatively. Of particular importance among them were two studies commissioned by the Department of Foreign Affairs and Trade (DFAT); ‘Economic Impact of an Australian-United States Free Trade Area’ prepared by the Centre for International Economics (CIE, 2001) and ‘An Australia-US Free Trade Agreement: Issues and Implications’ prepared by the Australian APEC Study Centre at Monash University (MU, 2001). Both were released in 2001 with the former focusing on the quantitative aspects and the latter on the qualitative aspects.

Another important report was prepared in February 2003 by the ACIL Consulting Private Limited (ACIL, 2003) for Australia’s Rural Industries Research and Development Cooperation with conclusions that were quite dissimilar with those found in CIE (2003). As such, a strong rebuttal was made by the CIE in a report published a month later entitled ‘Australia-United States Free Trade Agreement: Comments on the ACIL Report’(CIE, 2003). All the above-mentioned studies were released prior to the completion of the FTA agreement thus subjecting their conclusions and assumptions to changes. Accordingly, two months after the completion of the FTA negotiation in February 2004, the CIE updated its findings and release its report ‘Economic Analysis of AUSFTA: Bilateral Free Trade Agreement with the United States’ (CIE, 2004).

Below, I will provide a summary of the main arguments put forward in the reports.


The CIE Studies: CIE (2001) and CIE (2003)

            The CIE Study (2001) is very much in support of the FTA initiative. It represented an initial study to quantify the economic impact of the AUSFTA. The report concluded that; (1) Australia’s welfare would be 0.3 percent above that it might otherwise be. The figure would rise to 0.4 percent by 2010 and 0.5 percent by 2020; (2) Australia’s GDP could be 0.33 percent higher by 2006. It tested the impact of FTA on US and Australia under different scenarios (including complete removal of barriers, 50 percent removal of barriers and so on) and suggested that both countries would gain from the agreement; (3) the largest gain to Australia would be in sugar and dairy industries while the US gains in the manufacturing sector particularly the motor vehicles and parts industries (exports in Australia are expected to grow by 0.8 percent by 2006 with the dairy exports expanding by 350 percent and 2550 percent in sugar exports).

            As noted in CIE (2003), the main barriers to US trade (from Australia’s perspective) are in services. These include having the right to practice in the case of professional services such as lawyers, and right to establish a media outlet (CIE, 2003, p. 7). With the FTA, greater competition in the sector is likely to lower average cost of operations thus benefiting both the operators and consumers. It should be noted that a top-down negotiation technique is adopted in the negotiation meaning that the negotiation will start with the assumption that everything pertaining to services is subject to liberalisation unless otherwise stated in the negative list exceptions. The likelihood in liberalising the sector is thus enhanced.

            On the static effects of the FTA, the CIE study estimated that around US$1.8 billion of net trade creation would be gained. If the dynamic benefits are to be considered, it is unlikely that that trade diversion would dominate. Two reasons were advanced to explain why this is so. From the US’s perspective, theoretically the country may divert trade from the Asian, European and Latin American countries to Australia. This means that it is possible for US to import more from less efficient producers in Australia upon signing the agreement rather than importing the goods from more efficient producers in other countries. CIE (2004) explains that this should be minimal since both US and Australia are already very open countries. For those relatively heavier protected goods in the US like dairy, sugar and beef products, importing from Australia should not generate much trade diverting effects since Australia is already the least cost (or near least cost) producer.

            From Australia’s perspective, trade diversion could take place most notably in vehicles and parts industry (instead of importing from Japan and Europe for being more efficient producers than US). But as noted in CIE (2003, p. 11), a ‘US car is not a perfect substitute for a Japanese car. They are different products, albeit with a degree of substitutability’. In other words, product differentiation may cover-up to some extent the negative effects associated with trade diversion.


The Monash Study (2001)

            The Monash study provides a qualitative assessment of the pros and cons of signing the AUSFTA with particular emphasis on the former, and indicates the likely impact of the agreement on relations with other countries (especially in East Asia).

            The main benefits highlighted in the study are as follows. First, the FTA is expected to generate more investment from US and other countries in Australia. This may be attributed to the legal guarantees and other measures that raise a sense of security and certainty to the investors, all of which form parts of the FTA. Essentially, the study sees the importance of connecting with the US to boost US investments in Australia. Second, the FTA could expand Australia’s volume of trade over time. With the FTA, it is expected that trade barriers between the two nations will be removed in phases. Moreover, efforts to facilitate trade would be more forthcoming particularly in relation to improvements in institutional arrangements pertaining to businesses technical standards, recognition of professional qualifications and other regulatory issues (Stoler, 2003, p. 16). To justify the signing of the AUSFTA, the Monash study also noted a possible threat arriving from the formation of a Free Trade Area of the Americas (FTAA) - expected by 2005 – and other FTAs which may impede Australia’s competitiveness and ability to engage US in trade. As the study notes, ‘….given the likelihood of the US negotiating more FTAs in the future with more of Australia’s competitors, and Australian US FTA constitutes a potentially vital price of trade negotiating insurance’ (ACIL, 2003, p. xiv).

            Third, an important long-term benefit of the FTA is to allow Australia to benchmark best practices in the information age. Recognising the leadership role played by US, enhanced linkage with the US could increase Australia’s chance to flourish in the information age. Fourth, through the FTA, Australia could learn from companies, competitors, suppliers and customers in the US so as to keep in touch with the latest developments. Accordingly, this enhances the local companies’ ability to meet the US standards and raise their efficiency and profitability.

            From the discussion so far, it appears that both CIE (2001) and MU (2001) are in support of the AUSFTA. Alternative views were presented in the ACIL study.


The ACIL Study (2003)

            The ACIL study claimed that the gains noted in CIE (2001) and MU (2001) were modest at most in assessing the impact of the FTA. More specifically, the ACIL criticised the robustness of the CIE (2001) thus prompted the latter to counter argue a month after the released of the ACIL report (CIE, 2003). The arguments from MU (2003) and CIE (2003) are noted below.

            The ACIL claimed that the FTA could lower real consumption of Australia by five percent, which was much lower than a positive gain of 0.17 percent should there be a multilateral liberalisation instead. CIE (2003) believed that ACIL’s assessment was incorrect and inconsistent. The reason being that the ACIL findings suggested that real consumption would double if Australia pulled out of the Doha process (since Australia is already very open) and supported others to liberalise. But this did not seem to be ACIL’s recommendation for it actually suggested that Australia should move from US-Australia FTA to multilateral efforts (ACIL, 2003, p. vii).

            ACIL’s negative impression of the FTA could be resulted from its assumption that the services sector would not be liberalised from the agreement. ACIL’s argument is difficult to justify. The reason being that while there are some barriers to trade in the product market, the main barriers to US trade seem to be in the services. As such, emphasis in the negotiation would be very much placed on the liberalisation of the services which if realise, could lower cost and generate greater efficiency in production leading to improvements in the Australia’s welfare.

            This appears to be the case. In the agreement concluded in February 2004, Australia and US have committed to improve the environment for service trade which include ‘enhanced protection to guarantee market access on a non-discriminatory basis, and frameworks/agreements to promote and evolve the mutual recognition of qualifications in professional services, more liberal air services and cooperation in financial services’ (CIE, 2004, p. 10). This is a significant achievement given that in both countries, the services sector contributes to more than 80 percent to the respective GDPs. But quantifying the actual benefits is difficult because of the intangible nature of services.

            Turning to static effects, the ACIL unlike CIE, claimed that trade diversion would dominate thus imposing a negative effect on Australia’s welfare. It however did not provide any figures to substantiate its claim. The CIE (2003) did not agree with ACIL’s assessment. Particularly, the CIE felt that the ACIL had wrongly claimed that there would be trade diversion from Australia’s Asian markets because of increase in the country’s exports to US with no or little net gain to Australia. The CIE has noted very clearly that the problems associated with trade diversion would not come from the export side. In rebutting ACIL’s claim that the FTA diverts trade from Australia’s Asian markets to the US, the CIE argued that typical producers ‘export product to the most valuable market until the marginal return from each market is the same. Where they export is a matter of their free choice given the differences in barriers to trade, transport costs and so on that they face. If taking product from one market and sending it to another makes them worse off they will not do it. An FTA with the United States cannot make them worse off. Just because exporters may have gained greater access they do not have to use it’ (CIE, 2003, p. 10). Trade diversion, as the report argues, does not arise on the export side, but arises only on the import side (which as noted earlier would not be substantial both from the Australia and US perspectives).

The ACIL report and the response for the CIE had attracted a lot of attention from academia, politicians and the public, one of whom is Andrew Stoler, Executive Director of the Institute for International Business and Low at the University of Adelaide and former Deputy Director-General of the World Trade Organisation. After assessing the ACIL’s arguments and CIE’s responses, he is of the view that the CIE’s findings were more reasonable and solid. Stoler wrote, ‘There is some argument with the going-in assumptions given to the CIE, but overall the CIE’s study appears well-reasoned and documented and the CIE criticism of the ACIL methodology seems justifiable’ (Stoler, 2003b, p. 18).

            The above empirical studies were completed prior to the completion of the FTA negotiation between Australia and US. In this respect, it may be useful to refer to a recent CIE study which updated its earlier findings (CIE, 2004). In the new report released in April 2004, the CIE concluded that (among other things) (1) a decade from now, Australia’s GDP would increase by S$6.1 billion per year, or 0.7 percent higher than what it might otherwise be; (2), the country’s real GNP would increase by A$5.6 billion per year as compared to what it might otherwise be, and (3) the workers would enjoy extra employment and real wage growth over time. Quite clearly, the study further supports the institution’s earlier claim that the FTA would bring forth economic benefits to Australia.


What if Australia did not sign the FTA with the United States?

            Another way of looking at the pros and cons of the FTA is to ask ourselves what would happen if Australia and US chose not to negotiate for a FTA. Would Australia be better off?

            One of the arguments in support of FTAs is to allow pro-trade countries to go ahead with the negotiations to have more trade among themselves, rather than waiting for others to join in. As was mentioned earlier, while globalism and regionalism initiatives are the way forward, reaching a consensus among the numerous participating countries is problematic and time consuming. Furthermore, with the Asian financial crisis and 911 incident still fresh in many minds, the desire for some countries to integrate economically with the West has lessened. Stiglitz (2003) for example has argued that there is a growing anti-Americanism in Asia and Latin America (pp. 22-24) one of which is attributed to the country’s constant push for policies that were markedly different from those adopted by US. Indeed, reaching agreements in the WTO would not be easy if the developed countries fail to show fuller commitment to liberalise trade (the agricultural sector for example is still heavily protected in the developed countries). Regional blocs like ASEAN and APEC had also failed to push ahead with trade liberalisation. Accordingly, FTAs provide a viable alternative for countries like Singapore and Australia to enhance trade bilaterally and hopefully exert some pressures on others to move forward and proceed with the Doha process. In this respect, FTAs could be viewed positively.

            It has also been argued that failure to sign the AUSFTA would result in Australia losing its competitiveness. One of the reasons being that more and more countries are jumping on the bandwagon to strengthen bilateral trade relations despite their earlier refusal to acknowledge FTA’s net (Malaysia for example has expressed interest to negotiate FTAs with Japan and US). Regionally, the FTAA is expected in 2005 with the possible formation of ASEAN-China FTA. Australia is excluded from all these initiatives. As such, Australia’s level of competitiveness may deteriorate should it delay, or worse refuse to push for greater bilateral integration via the FTAs.

            There have been accusations that signing of AUSFTA would increase the probability of more trade blocs emerged among East Asian economies (particularly the ASEAN + 3 and ASEAN-China FTA) resulting in loss of trade opportunities between Australia and East Asian nations. Professor Ross Garnaut for example has noted that ‘the presence of trade diversion in an Australia-United States free trade agreement against East Asian countries would generate reactions that increase the probability of it (ASEAN-China FTA) happening’ (quoted in Stoler, 2003b, p. 20). But the reality is that Australia has to think what is best for her and not be overtly concerned about retaliations and constrained by others’ interest. There are other countries in the region which have gone ahead with the FTAs with or without considering Australia’s interest. This is the point made by Alan Oxley, principal author of the MU (2001). He wrote:

 ‘If the suggestion is that Australia needs to consider any proposal for strengthening its relationship with the United States, such as negotiating an FTA, in the light of its possible impact on relations with countries in East Asia, that is an altogether different proposition. Other countries in the region do not feel so constrained. And given that the strengthening of the relationship with the US is important to Australia’s economic and political interests, to suggest that actions to strengthen ties should not be pursued for their own merit must surely be to subsume Australia’s national interest to that of another country’s’ (MU, 2001, p. 90).

            Moreover, going ahead with FTA does not really imply a complete ignorant of globalism and regionalism efforts. Looking at the broad context of more trade, one can be in favour almost simultaneously of globalism, regionalism and bilateralism, a stance that the US, Australia and Singapore have obviously taken.

            Nevertheless, the AUSFTA negotiation has already been completed. A useful way forward is to ensure that the dynamic benefits are reaped, not only in the economics context but possibly strengthening relationship between member countries to fight against international crimes like money laundering, human trafficking, drugs smuggling and terrorism.


A concluding remark

            Two other issues have not received a fair amount of discussion in this paper. One is on the impact of the FTA on different sectors. Very briefly, for Australia, the sugar, dairy and beef industries are expected to gain the most, while in US, the largest gains are expected to be in the manufacturing sector particularly motor vehicles and parts industry (CIE, 2003). The second issue pertains to the debate on Australia’s commitment to multilateral and regionalism efforts given her interest to support bilateral trade agreements. Would the latter dilute Australia’s ability and commitment toward greater global and regional economic integration? Interested readers may wish to consult ACIL (2003) and Stoler (2003 a,b) which have discussed these issues and more.



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